I've heard some talk about the U.S. housing market being "not that bad" or headed for a "turnaround", but that's just not remotely true. Even if all the abysmal reports on falling housing starts (July '08 housing starts hit their lowest level in 11 years), plummeting prices, soaring inventories of unsold homes, etc., aren't enough, new foreclosures in the U.S. hit over 272,000 in July 2008. That's 55% higher than in July '07. So the market is being flooded with newly repo'ed homes for sale while prices skid lower and lower...in anyone's book, this does not make for a very bullish view of the housing market.

You could make the argument that this combination of factors makes real estate look pretty attractive as an investment (instead of the toxic recipe for disaster it actually is). There's some good logic there; as we all know, it's good to buy low and sell high. The only question is whether current prices are "low" or "high". Historically speaking, prices are still very, very high...coming off the bubble we're leaving, prices are going to have to fall a lot more than they already have before they qualify as "low".

Housing prices have already declined 20% nationally and as much as -36% in Phoenix AZ, -36% in Las Vegas NV and -35% in Miami FL. These declines may just be the tip of the iceberg. Loose lending standards have caused a severe real estate bubble causing U.S. home prices to increase nearly 150% inflation adjusted from 1995 to 2005. The US real estate market had a much greater inflation adjusted appreciation than Japans housing boom during the 80’s, and Japans market is still in a decline.

According to the Case-Shiller futures contract they are forecasting a larger decline in residential real estate. The Case-Shiller futures forecast a 34% peak to trough decline in residential real estate prices. Currently, the home price index has only declined 20% from peak to trough, which leaves an additional 14% of downside based on the futures price.

To clarify the Case-Shiller Home Price Index measures the residential housing market, tracking changes in the value of the residential real estate market in 20 metropolitan regions across the United States. The Case- Schiller futures are contracts that trade to forecast the future value of the Case- Schiller index.

Reasons why residential real estate may decline another 20%. 1) Case- Shiller futures predict a further decline in home prices. I’m a big believer in using markets to predict the future. The collective wisdom of a crowd is much more accurate than an expert at predictions. Also when money is on the line, it gives you a lot of incentive to do your home work and make smart bets. Therefore I believe the futures market are a terrific barometer of things to come. 2) Loan delinquency rates and foreclosure rates are on the rise. According to the Standard & Poor’s residential real estate indicators delinquency rates for all loans increased from 6.35% in Q1 2008 to 6.41% in Q2 2008 and sub prime delinquency rates of 18.67% in Q2 2008. Foreclosures hit 1.19% in 2nd Q 2008 up from .99% in Q1 2008 with a foreclosure rate of 4.7% for sub prime in 2Q 2008. And inventory levels continue to rise. 3) The Japanese real estate market increased 100% from 1980 to 1990, Japans housing prices are still in a decline and currently down around 40% from the high. See pic below. As a comparison the US house prices increased almost 150% in 10 years and are just 2 years and 20% into the decline. 4) According to the U.S. Census Bureau data, the home ownership rate is starting to decline. Currently the home ownership rate is at 67.8% which is down from the 2005 peak of 69% home ownership. However the home ownership rate is still very high compared to the 64% average home ownership rate from 1985 to 2000. That 5% differential (69% peak-64% average) represents home owners who would not have qualified for mortgages prior to 1994, when lending standards were eased and are largely characterized as Sub prime. I think home ownership rates will revert to the mean and get closer to the historical 64% average ownership rate. 5) Tight credit. The Federal reserve board loan officers survey, indicates increasingly tightened standards for residential mortgages, credit card loans and commercial & industrial loans. Asset backed security’s and Mortgage backed security’s issuance has fallen off a cliff. In October debt issuance in the US was down more than 89% YOY and at its lowest levels in the past 13 years. There are still a several billion dollars in auction rate securities that have been frozen for over six months. 6) It is still much cheaper to rent than it is to own, at least where I live. 7) The unemployment rate is up over 40% year on year and with all the big bankruptcy’s and layoffs the unemployment rate is headed much higher.

For the reasons mentioned above I think housing prices have another 20% of downside risk. Even though the futures market suggest housing prices will only come down another 14% this would bring the median price of a home to near the same level of 2002-2003. One can easily argue that the current state of the economy is much more dire, than the environment of 2002-2003 which saw all time new high levels of liquidity and home ownership rates on the rise. Bubble markets get overbought from greed on the way up and they almost always end with over selling from fear on the way down. Please visit http://ripetrade.blogspot.com/2008/11/home-prices-to-decline-another-20.html for further information and charts.

While nine of 20 cities in the index showed a price improvement in February and at least provided a glimmer of hope, remember that a prolonged decline often means the market requires a longer period of consolidation before it breaks higher over the long-term. Moreover, the market is fighting a fierce, triple-pronged headwind…

• Unemployment: With U.S. companies continuing to lay off workers in a desperate cost-cutting bid, this is hardly the kind of fertile environment that will kickstart enough home sales to cut into the bloated excess supply, drive prices higher, and improve the market. Unemployed Americans won’t even be thinking about buying new houses, never mind the struggle they’d face to get a decent loan or mortgage rate. As the job market goes, so goes the housing market.
• Confidence: The current economic and real estate climate has eroded confidence among would-be homebuyers. According to the Conference Board, the number of people who said they plan to buy a home in the next six months sank to a 26-year low in March.
• Excess Supply Of Housing: With America in the grips of a recession, jumping into a beleaguered housing market is low on Americans’ priority list. Existing home sales dropped by 3% from February to March and the U.S. Census Bureau said this week that the number of vacant homes hit a record 19.1 million in the first quarter. Plus, mortgage defaults and foreclosure rates are rising.

So expect to see home prices drift along rather aimlessly for now, while the punch-drunk market drags itself back together.

The mass of unanswerable questions facing investors navigating this market are nothing less than maddening. Will the economy depreciate back to its lows after such a strong rally? Will the Treasury plan to buy distressed assets help or hurt banks? Yet it is the most pivotal query, concerning when the housing market will recover, that will foretell the “homecoming” of risk to one’s portfolio. As of late the root cause of the economic downturn has been overshadowed, despite the extensive and relentless housing sales decline, by the housing derived chaos within the financial system.

Tim Geithner has finally announced the details of the Treasury’s public/private toxic asset sale proposal. Under the plan the government will buy mortgage backed securities using remaining TARP funds and leverage, while also lending money to a select few institutions to will buy the securities. While the plan provides the option to sell troubled assets, U.S. banks will be selling the assets for considerably less than the projected value over the long term and would be forced to write down more losses.

Able and rational banks will not choose to sell mortgage backed assets at a loss. Simultaneously financial firms are incentivized to return TARP funds as quickly as possible as they avoid losing their “top talent” to firms exempt from the stifling government compensation caps. Assuming that banks act in the best interest of their shareholders it is increasingly likely that these banks will not endorse further lending because such policies would put firms at a competitive disadvantage.

The Mortgage Bankers Association (MBA) has reported increases in mortgage applications in recent weeks due to 30 yr fixed rates hovering around 5% at prime. Some of the refinancing may stifle the rate of foreclosure, yet the national delinquency rate of home loans climbed at an accelerating pace to 7.88% in the fourth quarter of last year. Still more frightening is the level of sub-prime delinquencies, the same mortgages to which the banks’ “toxic assets” are tethered, which reached 21.88% in 2009 Q4.

In a press release on March 5, 2009, the MBA stated, “We will continue to see, however, a shift away from delinquencies tied to the structure and underwriting quality of loans to mortgage delinquencies caused by job and income losses.” The unemployment rate has continued to climb at an increasing rate from 7.6% to 8.1% in February and is expected to rise to over 9% by year end (the worst since early 1980’s), corroborating the projection by the MBA of more delinquencies in months to come.

It is important to consider the “worst case scenario” announced by the President and the Treasury, which will be applied to TARP recipient banks, which allows for 8.9% unemployment and a further 15% drop in home prices. Why would a first time home owner buy a home that may decrease in value by 15% during their first year of ownership?

While U.S. equity markets have made a roaring rally from 666 to 824 on the S&P 500, all evidence suggests that significant headwinds face the U.S. and global economy moving forward. Banks have not substantially increased lending, delinquencies and foreclosures continue to rise, the secondary effects of the jobless rate on the housing sector and broader economy have yet to be seen, and the sentiment of first time home buyers couldn’t be worse. It is delusional to anticipate the recent rally will lead us out of the recession we have endured for the past two years and miraculously change the real economic problems facing consumers and firms alike.

The single most influential forward indicator of a real housing rebound and a derived economic recovery is the level of unemployment, as job security determines the ability and willingness of consumers to buy homes. Until the acceleration of new and continuing jobless claims recedes it is prudent for investors to realize the true and dismal state of the economy.